Digimarc Corporation

Ladies and gentlemen, greetings and welcome to the Digimark Corporation second quarter 2023 earnings conference call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star and zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Joel Meyer, Chief Legal Officer. Please go ahead.

Thank you. Welcome to our Q2 conference call. Riley McCormick, our CEO, and Charles Beck, our CFO, are with me on the call. On the call today, we will provide a business update and discuss Q2 2023 financial results. This will be followed by a question and answer forum. We have posted our prepared remarks in the investor relations section of our website, and we'll archive this webcast there. Before we begin, let me remind everyone that today's discussion contains forward-looking statements that have risks and uncertainties. Please refer to our press release for more information on the specific risk factors that could cause our actual results to differ materially. Riley will now provide a business update.

Thank you, Joel, and hello, everyone. Q2 was a strong quarter on many fronts, a testament to our maniacal focus on being easy to begin doing business with and excellent at guiding customers along their product digitization journey. Starting with the easy to begin doing business with portion of our mantra, I want to highlight a few wins on the direct side of our business. We added two large new customers in the pharmaceutical vertical and are hard at work expanding this flywheel to help this industry combat the massive and massively important issue of counterfeit products. We also close deals with two separate divisions of a top 25 global CPG for a sandbox version of our platform involving factory automation and are working to pull together the ecosystem partners necessary to provide a quickly scalable and low touch solution to the hundreds, if not thousands of other companies that would benefit from the same. Based not just on these two initial wins, nor just on our internal research, but very importantly, also on our growing pipeline of opportunities as the word gets out, we are confident we have a truly differentiated and high-value factory automation solution that we can't wait to provide to many others. On the channel side, we added two new VARs, including the large $32 million-plus contract we announced a few months ago. We have high expectations that both relationships will grow as we prove DigiMark illuminates value in allowing our VARs to provide unique, and differentiate solutions to their own customers. In addition, the public announcement of our large VAR deal has put us squarely on the security printing industry's radar. We are in early conversations with two new prospects, each of which represent a sizable opportunity. This further validates the unique position we enjoy in this space, based not just on Illuminate's capabilities as the world's best product digitization hyperscaler, but also DigiMark's hard-earned and well-deserved reputation with this industry, gained by over two decades of delivering value to the world's central banks. In addition to the opportunities opening to us in the security printing space, the day after we issued that press release, we received an invite to a full-day planning session for a proposed deposit return system program in a major country. We are focused on expanding our opportunities in the DRS market, as we believe our Illuminate platform provides our VARs the ability to offer a DRS solution that is easier, more comprehensive, and more cost effective than the status quo. As part of the excellent at guiding customers along their product digitization journey portion of our mantra, we signed multi-year extensions with six important customers in Q2, five of which resulted in the meaningful increase in annual recurring revenue, a testament to the power of our technology and our team. Four of these renewals were direct customers, and the other two were ours. In addition to these contract renewals, we also had two customers whose contracts were structured under the legacy pay-as-you-go model significantly ramp up their usage in Q2, including a top five global CPG that is also a key supplier to Walmart. All of the above help contribute to strong results in the two key financial metrics about which we obsess. While Charles will elaborate more in a moment, I want to highlight subscription revenue is up 44% year over year and 59% when adjusting for the end of life of piracy intelligence. In addition to strong subscription revenue growth, subscription gross margin expanded 400 basis points sequentially to a near best in class 84%. with further expansion ahead as we continue to remove costs from our platform and add high incremental margin subscription revenue. Before I turn the call over to Charles, I want to take this opportunity to answer a question I know is front of mind for many of our investors. Yes, our technology does have a significant role to play as the world grapples with both the opportunities and the dangers of generative AI. And as we've been busy preparing our soon-to-launch offering, informed by all the learnings and knowledge that comes from being the pioneer and widely recognized vanguard of digital watermarking. It has been wonderful to see some of the world's largest companies and governments conclude the same. We also applaud the various governments and Gen AI companies who are moving to act on this conclusion, including most recently the seven leading AI companies who convened at the request of the White House and voluntarily committed to take specific steps. The world seems to be coalescing around the view that safely and securely unlocking the transformational power of Gen AI will require addressing its biggest dangers head on. A view we not only share, but one we are uniquely positioned and excited to help achieve. And no bigger problems need solving in the world of Gen AI than how to ensure the authenticity of digital media and how to provide for the safety and fairness of the input to the models themselves. We believe there's an obvious need for a single, robust, secure, and easy-to-adopt solution that can accomplish both, while also adding additional value to stakeholders in the world of Gen AI and beyond, and are anxious to begin telling that story more broadly. But today, I want to focus more specifically on each of these two potentially show-stopping problems in turn. Regarding the need to ensure the authenticity of digital media in a world where digital asset creation is easy, fast, and cheap, While the current proposal of tagging all Gen AI created output is a solid first step, if for no other reason than it shows that the Gen AI companies are serious about taking action, it won't solve the problem of how to ensure the authenticity of digital media for the following four reasons. First, unless every Gen AI company applies digital watermarks to its output, which is an impossibility for many reasons, simply tagging the Gen AI created content of some will do as little to prove authenticity as if it were done by none. Intuitively, no one would suggest the system we have built alongside the world's central banks to help protect the authenticity of currency should rely on every potential counterfeiter, current and future, printing the word fake on their counterfeit currency. The same logic applies here. Second, a solution that rests solely on digital watermarking Gen-A output assumes there are only nefarious or frivolous uses of Gen-AI, an assumption with which we, along with many others, disagree. An incredible amount of legitimate content is already being produced with the help of GenAI, and the value creation potential of GenAI is still in its infancy. Similar to how the output of copy editors improve with the advent of spellcheck, the work of professional creatives will improve by incorporating GenAI. GenAI is a generational productivity tool that should and will be used by legitimate creators of digital assets. And what truly matters is whether a digital asset was created by the source one believes it was, not the method or tools used in its creation. Third, authentic content used in an inauthentic context is often worse than just lacking certainty by the digital ad's native authenticity because this scenario provides a false sense of comfort. Context about when and why authentic content was created and used matters, and it matters a great deal. To wit, an authentic image of a medicine that appears in an inauthentic place, such as the website of an unauthorized or otherwise illegitimate reseller, will without doubt increase the odds a consumer mistakenly purchases a potentially dangerous item. Content and context are two sides of the same authenticity coin. And finally, many Gen AI engines rely on open source technology, which essentially gives anyone the keys to inspect, understand, and potentially even edit lines of codes, including those lines involving security. There's a reason why network security companies don't build their business around open source technology, And the same logic applies when it comes to a system tasked with ensuring the authenticity of digital assets. For these reasons, simply watermarking GenAI-created output will not adequately ensure the authenticity of digital content. Moreover, there's another crucial issue that must be addressed. The world also needs safe and fair filtering of the content that trains these engines. Several groups have an immediate need for these safeguards. First are the companies and creatives who have spent an incredible amount of talent, time, money, and effort to create their digital assets. This is exactly why copyright law exists in countries around the world. Without an automated safe and fair input filter, these assets have simply become free input to the trading of Gen AI engines without the copyright owners having a say. That isn't fair, and in many cases, it isn't legal. Second are the Gen AI companies themselves. They need a solution that allows them to comply with copyright law, or they risk the exponentially growing avalanche of lawsuits overwhelming their legal teams as well as their balance sheets. And the only alternative being considered, unilaterally restricting the input needed to train their engines, will deprive the world of the productivity gains their useful and powerful technology will bring. In addition, the Gen AI companies also face a second still in its infancy avalanche of existential risk, namely model collapse. Because without an automated way to filter the quality of input along multiple different vectors, the models will suffer ever-decreasing quality of output until they asymptote to worthless. The universal law of GIGO, garbage in, garbage out, applies in the world of Gen AI, too. And finally, beyond these two game-over risks, the current processes being applied to Gen AI model training could be made much more efficient in multiple ways if a robust automated input filter that also allowed for identification were applied. And third is a group much larger than the first two combined, a group comprised of 8 billion people. We're all stakeholders in stopping our memories, such as the pictures of our children, from being used and monetized without our knowledge, let alone our permission. One of the statements coming out of the White House on this topic a few weeks ago was, the highest standards must be upheld to ensure that GenAI innovation doesn't come at the expense of Americans' rights and safety. Extend that statement to all country citizens, and we wholeheartedly agree. A system that allows for an extensible and adaptable opt-in and opt-out filter benefits all, and we are excited to soon offer the world a single system that will allow for that, instilling confidence in content authenticity, and a whole lot more. In sum, some of the brightest minds in the world, spanning both the public and private sectors, have instinctually understood that, yes, our technology has a role to play in what will likely prove to be the most powerful technology advancement since the internet itself. And importantly, they've shown a willingness to act to address the problems that must be addressed to unleash this power. We applaud them and are excited to build upon the foundation they have set. Due to our legacy, experience, and unrivaled expertise in digital watermarking, we have a meaningful role to play in solving the problems at hand. DigiMark will deliver a solution that provides for authenticity, security, safety, and protection of rights, a system that benefits all. As we finish up the work we have been doing ahead of the launch, we are thankful for the positive reception we are already receiving with some incredibly important stakeholders and are excited to unveil more soon. I will now turn the call over to Charles to discuss our financial results.